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Goldman Sachs and the "Long Good Buy"

The case for an undervalued stock market.

U.S. financial powerhouse Goldman Sachs(NYSE: GS) has been called many things. "Giant vampire squid" was one memorable description in an article in Rolling Stone. "Toxic and destructive" is a more recent label, made by a resigning Goldman employee in a New York Times letter that prompted headlines around the world.

For all the debate about Goldman's ethics, however, you rarely see people questioning the firm's market savvy. The company that brought us the BRIC label in 2001 and so drew mainstream attention to emerging markets -- to give just one example -- often seems one step ahead.

The report is somewhat lengthy and includes a fair few technical terms and diagrams. But the bottom line is Goldman's economists think it's time to say goodbye to government bonds, and that equities are in contrast a "good buy."

Such entertaining punning is wasted on investment bankers -- they should come work at The Motley Fool!

But, more important is the report's core thesis, which I happen to agree with -- that government bonds look overvalued by historical reckoning; and in contrast, equity valuations seem unreasonably low.

I'll try to summarize Goldman's report in a few hundred words, but obviously I'll have to simplify. You should also note that I am definitely at the bullish end of the PRO team spectrum when it comes to equity valuations. Nate and Nathan, the two PRO analysts, are much less confident that the market is a great value than I am, although both are still fairly positive on a medium- to long-term view. And I certainly agree anything can happen in the short term!

With the reminder, then, that it takes many views to make a market (so don't even think about ploughing your life savings into shares on the back of Goldman's note), here's a summary:

1. Equities have significantly "de-rated"Around the turn of the century, the dot-com boom pushed share valuations -- measured by metrics such as the P/E ratio -- far above long-term averages. Since then we've paid for it with lower returns.

Over the past 12 years, those elevated ratios have come down, even as corporate profits have advanced. Goldman notes that this "de-rating" has been painful, stating that "the last few years have seen the worst returns in U.S. equities (along with the 1970s) in over 100 years."

While Goldman does point to a graph of equities versus gold among its many illustrations of this de-rating, it's against government bonds that the underperformance of equities is perhaps most significant.

Investors should expect to (eventually) enjoy a higher return from holding equities than from bonds as a reward for putting up with all the share-price ups and downs. But in the U.S. and most other markets, as bonds have surged higher and equities have fallen over the past decade, Goldman notes, "Annualized excess returns in equities compared to government bonds have been the most negative over the past decade as in any period since 1900."

The bank concedes this may be at least partially corrected with the demise of what it calls the "cult of fixed interest," which has seen U.K. pension funds cut their direct holdings of shares by two-thirds since 1990.

Bond investors may start to demand higher yields from their new purchases, regardless of equity valuations. But even if bond prices fall and yields rise, Goldman argues that won't necessarily be bad news for shares, since it will probably coincide with improving economic conditions.

Another example it gives of the lowered valuation being put on shares is the number of years of retained cash flow it would take for listed companies to buy the market outright. This so-called "takeover recovery cost" was at 221 years for the European market in 2000 and was still at 221 in 2006, according to Goldman's figures. It would now take just 17 years.

2. This cheaper valuation will drive future returnsGoldman has lots of other graphs and metrics showing how investors aren't expecting much from equities in the future. In fact, it believes that by some measures, investors seem to be expecting a real-term fall in corporate profits for each of the next 20 years!

But why should this change? Well, Goldman's economists say people are too hung up on the weak economy, and they question the relevance of the economy compared to valuations in driving returns. In contrast, the economy was strong for much of the past decade, but it didn't do much for Western stock markets due to that previous overvaluation.

Instead, Goldman finds that a sustained period of weak returns for shares is usually followed by a strong one, stating:

Once the news is fully priced, investment outcomes tend to improve. ...

[Looking at] U.S. data back to the start of the 20th century, that there have been only 17 years when the annualized real return has been negative. ...

The subsequent five-year annualized return was positive in all but one period, 1967, followed by the start of the high inflation of the 1970s, and in this case the annualized loss was around -0.2% in real terms. ...

Of the 14 periods for which we have data, five experienced double-digit annualized real returns. ...

The report says the findings were similar for the U.K., although the data is more limited.

I don't know about you, but I'd be happy to receive double-digit real returns for the next five years from my shares, if that's what comes to pass. (Not even Goldman is saying that will definitely happen. It's just putting decent odds on the possibility, going on past data.)

3. Doubts about the future are overblownFinally, Goldman's analysts take aim throughout the report at the various counterarguments leveled against this optimistic view for equities.

Summarizing and simplifying:

Margin contractionAt the moment many companies are extremely profitable by historical measures, due, for example, to cost-cutting, lower wages, and cheap credit. Goldman believes these factors -- plus the impact of technology -- could keep margins higher for longer than some might expect. But, even if margins do inevitably fall, Goldman thinks this is largely in the price.

DemographicsSome argue that the Baby Boomer generation's turning from savers into spenders will reduce returns, and they point to academic studies correlating demographics with returns. Goldman retorts:

There are plenty of young people growing richer outside of the West who will want to invest.

Baby Boomers may hold equities for income.

Markets should have priced in an aging population long ago.

Companies have lots of cash, which may support valuations.

Japan and deleveragingThe two-decade bear market in Japan is often raised as an example of what a post-boom period looks like, especially after a credit bubble. Goldman retorts that overvaluation in Japan was much more extreme and more widespread and took longer to be recognized and resolved, and it points to graphs showing that the Japanese experience is actually an outlier when it comes to downturns.

The bottom line: Buy sharesThe Goldman Sachs report is fairly even-handed in my view, even if it reaches a positive conclusion on equities. And Goldman does concede that we could be in for what it terms a "flat and fat" period, where stock markets go up and down in a wide range as growth fails to return to the underlying economies.

The report argues that such periods typically start with obvious overvaluation, however, which Goldman doesn't think holds true for shares today.

In fact, Goldman believes the next 10 years will see a new peak in global growth, and that "the prospects for future returns in equities relative to bonds are as good as they have been in a generation."

We'll all have to make our own minds up, but hopefully the cautious, bottom-up company-focused approach of PRO will help us do well if Goldman is right -- and at least partially protect our portfolio from general falls in the market if the bank is wrong!

This commentary was written by Owain Bennallack, an analyst for our London bureau's Champion Shares Pro service. Owain does not own shares of any companies mentioned.